Stating the obvious, General Partners are capitalists. They spend most of their time working with portfolio companies on development, production, pricing and distribution — in order to ultimately harvest profitable investments. As a reward for their efforts, investors reward GPs with a meaningful share of investment profits, in the form of carried interest. The carried interest from successful funds can be incredible wealth generating vehicles, but so can the management fees that are created when you apply the standard 2% against ever-increasing fund sizes. Thinking like rationale capitalists, successful GPs have sometimes raised substantially larger funds that generate larger sums of management fee revenue.
A great historical example of this occurred in the venture capital market during the late 1990s, when leading early-stage firms began raising funds with $1 billion targets. The tension and internal struggle that these top-tier managers endured when deciding on future fundraising targets must be intense. When managers raise oversubscribed funds, they are essentially turning away unfulfilled consumer demand. However, if they meet the consumer demand, they may be sacrificing profits from carried interest if they drift away from the firm’s core investment strategy. But like I said, General Partners are capitalists.
Since the start of the year, in discrete conversations, three top-tier private equity managers have said that they are considering major brand extensions as a way to capture unfulfilled investor demand without sacrificing investment strategy (i.e. carried interest). Each of these firms was considering the launch of sub-debt funds, industry-focused vehicles, country-specific funds, growth capital strategies and/or all of the above — in order to increase assets under management. At the end of the day, it’s all about hanging another shingle, building the platform, growing the empire or, to put it bluntly, making more money.
But why go through the trouble? Why not use a simple economic mechanism to solve the problem? If a top-tier manager is oversubscribed, by definition, it has supplied less inventory than the market demands. In a properly functioning market, supply and demand dynamics find equilibrium. In the private equity market, however, the prices a manager charges its investors are historically fixed at approximately 2% management fees and 20-25% carried interest. In a market with supplier-driven inventory limits, structural price ceilings and excess consumer demand, the consumers, in this case Limited Partners, are benefiting from significant consumer surplus. It would be very easy for the most elite private equity managers to force the market for their product towards equilibrium with a capitalistic hallmark: The Auction.
Imagine a world where instead of sending out a fax or email to LPs asking for an indication of interest for the next fund, top-tier managers also ask for the maximum carried interest they would be willing to pay. The auction dynamics between universities and public plans for access to firms like Sequoia or Kleiner could be very interesting. Bidding rationale would of course be driven by the manager’s perceived quality and track record, but also by the limited partner’s opportunity set and investment needs. Would a public pension fund think twice about giving Sequoia a 50% carried interest if its alternative opportunity set was a list of “me-too” managers with 2nd and 3rd quartile track records? In order to find out, we conducted an informal survey to simulate an auction with more than thirty-five limited partners. The auction involved an anonymous top-tier manager who, net of their 25% carry, had consistently delivered multiples of 0.9x – 11.3x to investors. The manager was limiting its next fund size to $250mm, but would allocate commitments based on carried interest bids.
Bids ranged from 22.0% to 72.5%, but the market clearing carried interest level was 42.50%. Basically, these investors were willing to increase the managers carry by 70% in order to ensure participation in the new investment opportunity.
The market ramifications of carried interest auctions likely makes the idea almost impossible to implement, but it is interesting to contemplate the impacts that such a structure could have on the market. For example, what if emerging managers contractually guaranteed investors in their first fund that portions of successor funds will always be available to original investors at the original, non-market priced, carried interest level? If the emerging manager evolves into tomorrow’s top tier manager and commands a 40%+ carry, original investors still have a portion of the fund for themselves at the original 20% carried interest level. Thus, emerging manager investors actually have a true economic reward for risking capital with less experienced teams.
Dan and the PEHUB collective can probably envision dozens of implications and I am curious to hear thoughts from the market.